May 2023 Stock Market Forecast

In May, investors discounted the debt ceiling drama and forgot about the banking crisis, focusing instead on the tantalizing prospect that the Federal Reserve might be close to pausing rate hikes.

The S&P 500 was up less than 1% for the month, although things went out on a high note as President Joe Biden and House Speaker Kevin McCarthy began the process of rallying their troops in Congress to support a preliminary debt ceiling compromise.

If the Biden administration and the Congressional Republicans manage to raise the debt ceiling and avoid a U.S. default, the stock market could sustain its bullish momentum for a little while longer.

Nevertheless, there are lingering fears about a potential recession later in 2023—as there have been for at least 10 or 11 months at this point. For now, investors are taking hope from the decent first quarter earnings season and a possible Fed pause, which sets the table for a solid market in June.

With Inflation Cooling, Fed May Pause Rate Increases

The two key market catalysts that have gotten the most headlines in the past year remain front and center: inflation and interest rates.

The consumer price index gained 4.9% year-over year in April, down from peak 2022 inflation levels of 9.1% but still well above the Fed’s 2% long-term target.

At a conference in May, Fed Chair Jerome Powell said inflation is still too high and the central bank would remain “steadfast” in pursuing its goal of price stability. Powell said the recent U.S. banking crisis that led to the collapse of Silicon Valley Bank, Signature Bank and First Republic Bank has tightened credit markets and likely weighed on economic growth and inflation.

“So as a result, our policy rate may not need to rise as much as it would have otherwise to achieve our goals,” Powell said.

The Federal Open Market Committee raised interest rates by another quarter of a percentage point in May, its tenth consecutive rate hike since March 2022. Powell said current policies are “restrictive,” and warned that the Fed will “look at the data and the evolving outlook” before making an interest rate decision at its June meeting.

Quincy Krosby, chief global strategist for LPL Financial, says another rate hike could be on the table in June if May inflation data comes in hotter than expected.

“In terms of a ‘pause’ at the upcoming meeting, there has been much equivocation, but the data dependent Fed will have a raft of data available before its rate decision on June 14,” Krosby says.

She says the FOMC may prefer to risk raising rates more rather than pausing too early.

“Jerome Powell has been particularly critical of the ‘stop and go’ monetary policy in the 1970’s that contributed to the stagflationary underpinning of the economy, and which required an aggressive monetary policy to restore price stability,” Krosby says.

The bond market is currently pricing in a 28% chance the Fed will maintain its current fed funds target rate range in June and a 72% chance of yet another 25 bps hike, according to CME Group.

U.S. Recession Watch

The U.S. economy appears to have dodged a bullet with Congress very close to passing a debt ceiling compromise, which would prevent a potential U.S. government default.

After weeks of tense negotiations, Speaker McCarthy and President Biden agreed to a compromise proposal that would raise the ceiling in exchange for a cap on federal baseline spending for the next two years.

The bill must now pass the House and Senate before June 5, the date on which the Treasury has estimated the U.S. would be unlikely to continue to meet its debt obligations.

With the debt ceiling deal seemingly in place, the Fed is reaching a critical point in its battle against inflation, and the next couple of months could determine whether or not it can navigate a so-called soft landing for the U.S. economy without tipping it into a recession.

In recent months, the U.S. housing market has softened significantly, and manufacturing activity has dropped. In addition, the U.S. Treasury yield curve has been inverted since mid-2022, a historically strong recession indicator.

So far, the most convincing argument a soft landing may still be possible has been the resilience of the U.S. labor market. The Labor Department reported the U.S. economy added 253,000 jobs in April, exceeding economist estimates of 180,000 jobs added. U.S. wages were up 4.4% year-over-year, and the unemployment rate remains historically low at just 3.4%.

DataTrek Research co-founder Nicholas Colas says positive price action in the corporate bond market suggests recession fears may be overblown.

“For all the recession worries over the last 12 months, corporate bond spreads have never really taken this bait and even now are at levels consistent with the average readings over the last economic expansion,” Colas says.

He says the corporate bond market has an impressive track record when it comes to predicting recessions.

“The fact that this market continues to shrug off recession fears is therefore a reassuring sign for equity investors,” Colas says.

However, Bank of America economist Ethan Harris is expecting a U.S. recession in 2023.

“GDP growth slowed down to 0.9% in 2022 (4Q/4Q) and we now expect it to decline further to -0.2% in 2023 (4Q/4Q) as the lagged effects of tighter monetary policy and financial conditions cool the economy before recovering by 4Q 2024,” Harris says.

He says the economic slowdown will eventually lead to much-needed disinflation.

“Our forecast still puts inflation broadly in line with the Fed’s 2% mandate by 2024 end,” Harris says.

Earnings Slowdown

Rising interest rates and a downturn in consumer confidence is a bad combination for S&P 500 earnings growth.

More than 95% of S&P 500 companies have now reported first-quarter earnings, and the blended earnings growth rate for the quarter is roughly -2.2%. The first-quarter will be the second consecutive quarter of declining S&P 500 earnings.

The earnings slowdown has hit some market sectors harder than others. Consumer discretionary sector earnings are up 53.9% in the first quarter, while industrial sector earnings are also up 22.5% from a year ago. Materials sector and utilities sector earnings are down more than 20% each in the quarter.

Looking ahead to second-quarter reports, analysts are calling for S&P 500 earnings to fall 6.4% compared to a year ago. Fortunately, analysts are projecting S&P 500 earnings growth will rebound back into positive territory in the second half of 2023.

Analysts expect 0.7% earnings growth in the third quarter and 8.1% growth in the fourth quarter.

How To Invest in June

While the economic outlook for 2023 remains uncertain, there are reasons for investors to be optimistic in June and beyond. The S&P 500 was up roughly 9% on the year as of May 25, the 100th trading day of 2023. Since 1950, when the S&P 500 has been up at least 8% on the 100th trading day of a calendar year, the index has averaged a 10% additional gain for the remainder of the year.

The last time the S&P 500 was up more than 8% on the 100th trading day of the year was 2021, and the index finished 2021 up 26.9% for the year.

However, investors concerned about the potential for a U.S. recession can also take a more defensive approach to the market and increase their financial flexibility in 2023 by dialing back exposure to stocks and increasing their cash holdings. Investors can already earn 4% or higher in online savings accounts heading into June, and those interest rates will likely remain elevated for at least the next several months.

Value stocks have historically outperformed growth stocks when interest rates are high, and growth stocks lagged value stocks by a wide margin in 2022. However, that trend has reversed so far in 2023 as investors anticipate an end to rate hikes and even a potential Fed pivot to rate cuts by the end of the year.

The Vanguard Value ETF (VTV) has generated a total return loss of 2.6% year-to-date, while the Vanguard Growth ETF (VUG) has generated a positive total return of 25.1%.

Adam Turnquist, chief technical strategist for LPL Financial, says there’s a strong case for the S&P 500 to break out to new all-time highs in the coming months.

“Given the continued technical progress for the broader market and the potential end to the Fed’s rate hiking cycle, a change in sentiment may be on the horizon, while pressure to cover historically high short positions builds. What does this mean for the S&P 500? It could be a relatively quick trip toward the August highs near 4,300,” Turnquist says.